How to get the lowdown on diggers and drillers for 2016

As we approach the end of 2015, the FTSE 100 is down by 8% to 10%, weighed down by two sectors in particular – oil and mining. 

Fellow heavyweights pharmaceuticals and banks have hardly covered themselves in glory either, with declines of 6% and 19% this year but those efforts look good compared to the diggers and drillers.

As 15 December, the FTSE All-Share Oil & Gas Producers sector was down by 26%, and FTSE All-Share Mining by 52% - enough to leave them pretty much at the bottom of the sector performance rankings.

The question that therefore faces all investors as we get ready for 2016 must therefore be is now the time to start looking at these downtrodden sectors once again?

There is no-one size fits-all-answer here. The stocks in both sectors are likely to remain volatile and may therefore only be suitable for patient, risk-tolerant investors aware of, and prepared to embrace the risk of, the dangers of capital loss.

There may be some juicy dividend yields on offer but Glencore and Anglo American have already cut their payouts, suffering big share price drops as they did so. There is no point chasing a fat yield if any share price falls mean capital losses could erase the benefits of that income, or if the dividend is subsequently cut.

Ultimately, as an individual investor you must first decide whether oils and miners fit with your individual overall strategy, time horizon, target returns and appetite for risk. If so, you must then do your research on the raw materials the companies produce and then on any individual stocks before you then judge whether valuations are appropriate or not.

Tough times

Oils and miners have been awful performers in 2015. Regular readers will recognise these charts. They show the weekly performance ranking of Oils and Miners in relation to all 39 FTSE All-Share index sectors.

One is best, 39 the worst and as you can see oils and miners now stand at 37 and 38 respectively.

Source: Thomson Reuters Datastream, SHARES Magazine

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

That is not good but is also history. The financial markets are forward-looking and the key now is what are these stocks going to do, not what they have done.

We all know the news is grim:

• Brent crude oil trades at near seven-year lows at $38 a barrel (and any falls below $36 would take it to 2004 levels)
• The Bloomberg Commodity index stands below 80, a mark not seen since 1999
• Some miners are cutting or passing their dividends, other are tapping them for extra cash via placings and rights issues
• Earnings forecasts are under pressure

The only good news is we know all this already. Investors must now decide:

• Whether things can get worse
• Whether things can get better
• Whether all of the bad news is in the price

The third point is perhaps the most important one because valuation ultimately determines your return from any investment. 

This is a complex issue, especially as oils and miners’ earnings swing around a lot. In theory you should buy when earnings are depressed and the stocks look expensive (because in principle profits can only get better and if they get better the shares could rise) and sell when earnings are high and the stocks look cheap (because in principle profits can only get worse and if they get worse the shares could fall).

Relatives for Christmas

One rule of thumb which can help to cut through this noise is to look at price relatives. If a sector or stock trades at a multi-year low relative to a benchmark then there has to be a chance the bad news is already reflected by its performance.

The FTSE All-Share Mining index in its current form dates back to 1986 – and a 30-year history is quite long enough for our analysis.

This chart shows the Miners’ relative performance, by dividing the FTSE All-Share Mining Index by the FTSE All-Share itself. If the line rises, Miners are outperforming, if it falls they are underperforming.

Source: Thomson Reuters Datastream

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Miners have underperformed horribly for the past few years but unfortunately the UK mining sector still trades at twice its historic low, relative to the FTSE All-Share. 

This suggests that the worst may not be over yet, if history is any guide. If history does play out, either the miners will fall faster than, or rise more slowly, than the All-Share. 

Remember also that there are still seven miners in the FTSE 100: Anglo American,
Antofagasta, BHP Billiton, Fresnillo, Glencore, Randgold Resources and Rio Tinto

More than one wise – and experienced – fund manager has whispered to me that he will only be tempted to look at the mining sector when that figure has fallen to one, replicating the mass inrush and then outflow of technology, mining and telecoms stocks which characterised the 1998-2003 period. Over 20 techie firms swished into the index and all but a couple sluiced out just as quickly.

Sticky oil

When it comes to the oils, here is the same sector relative chart.

Source: Thomson Reuters Datastream

NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

The good news is the oil sector is trading within 10% or so of its 30-year relative low, as compared to the FTSE All-Share Index.

It’s also possible that the oil stocks are to be further down the road than the miners in adapting to the new reality of lower prices, although December’s inconclusive OPEC meeting in Vienna is prompting fresh drops in Brent crude to below $40 – and the big oil firm’s cost-cutting and capex plans appear to rely on $60 a barrel or more

In sum, oils look to factor in more bad news than miners and there are just three left in the FTSE 100 – BG, BP and Shell and BG is due to disappear next year. 

This is still no guarantee for the future and patience will be required in both cases, even if they do start to turnaround. Self-help programmes, in the form of plans to slash costs, reduce capital investment and pass dividends are a good start but what both sectors really need is a rally in underlying commodity prices. Without that boost they may continue to struggle, judging by recent market action. 

Russ Mould,

AJ Bell Investment Director